Buy the dip

Commentary: Considerable upside left in energy service stocks

RonRowland

AUSTIN, Texas (ASFT) -- At the end of last week, energy service stocks were off some 5 percent from the Jan.30 peak, as measured by the Philadelphia Oil Service Sector Index.

We view this and any further weakness as a buying opportunity. Given Monday's action, we may not be alone in our thinking.

Short term sentiment is decidedly bearish, as most pundits seem to think last years gains cannot be repeated. One cannot find a newspaper or magazine without an article detailing the recent strength in the energy sector. These are signs of the proverbial wall of worry. Savvy investors know that going against the grain can yield substantial rates of return.

What nobody is talking about

The market capitalization of the energy sector as a percent of the entire Standard & Poor's 500 Index
SPX, -0.14%
today is 10.3%. Why is this an important figure? First, let's review some history. In 1992, technology represented only 6% of the S&P 500 and grew to 19% in 1998 and 30% in 1999.

In contrast, energy's S&P weight climbed from 7% in 1972 to 22% in 1979 to 28% at year-end 1980. No, that is not a typo; the energy component was a whopping 28% at the end of 1980. We are nowhere near that level today. In fact, the energy complex could be eerily similar to the mid 1990's when technology began its initial ramp and ultimately crested over 30% in the early 2000's.

Could energy be on a similar path? Yes. Did many investors consider shares of Netscape, Iomega, 3Com, US Robotics, AOL, and Presstek over-valued even during the first wave of the build-up, in say, 1996? Of course. Do you find, when discussing energy stocks today, that many times you get the cold shoulder, with comments such as those stocks have returned 50% in the past 12 months and they can't possibly go any higher? Yes.

What does this mean? Undoubtedly, you have the variant perception, you view the market differently than most others, and excess return can be had if you stick to your disciplined strategy. With the energy complex, it means you stay long and strong, in the face of the doubting Thomas'.

Overlooked: China and Saudi Arabia

Two weeks ago, Chinese and Saudi Arabian officials reached a landmark accord on oil, natural gas, and other minerals. Chinese President Hu Jintao said, "China is willing to improve the dialogue and the method of cooperation on energy with Saudi Arabia to raise the level of energy cooperation."

Neither side provided any details of the agreement, but Saudi Foreign Minister Prince Saud al-Faisal underlined Hu's remarks on hydrocarbons as a main theme of the summit, saying, "China is one of the most important markets for oil and Saudi oil is one of the most important sources of energy for China."

Why is this important? I found little, if any coverage of this summit in the mainstream press. That in itself has important investment ramifications. What it also means is this: the cyclicality in energy continues to diminish, and it's going to be a bull market in energy through the end of this decade. A major deal between China, with an insatiable and growing thirst for oil, and Saudi Arabia, the most relevant of all oil producing nations in the world, but one with a declining infrastructure and questionable reserves, means energy prices are likely to remain high.

This is in contrast to most observers who continue to proclaim the price of oil will decline below the $50 level. In fact, could it mean we are more likely on pace for what Goldman Sachs calls the super spike phase and $100 per barrel oil? We think so!

Bottom line, if we are even half right about the energy bull market having some upside left, that move can be substantial. And if the herd ultimately comes into the sector, much like the tech stampede in the late 90's, significant returns can be achieved.

We'd be an aggressive buyer of Oil Service Holdrs
OIH, -1.38%
Rydex Energy Services
RYVIX, -1.21%
Fidelity Select Energy Service
FSESX, -1.07%
and PowerShares Dynamic Energy Exploration & Production
PXE, -0.54%
at current prices. On Friday, there was strong support at the 200 level for the Oil Service Index
OSX, -1.29%
which is approximately 5.8% less than current prices, so buy any continued weakness aggressively.

Ron Rowland is president of All Star Investor.com and Capital Cities Asset Management. He's been editing the All Star Fund Trader mutual fund newsletter since 1990. Rowland currently has positions in OIH, RYVIX, FSESX, and other energy positions outside the service sector. Additionally, a number of the funds mentioned in this report are held in client accounts. (allstarinvestor.com)

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